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FINC 5880 Session 5 Mid-term Examination 2014




Question 1. (10 points) The exercise price on one of ORNE Corporation\'s call options is $25 and the price of


the underlying stock is $29. The option will expire in 35 days and is currently selling at $5.50.


a. Calculate the option\'s exercise value? What is the significance of this value?



b. Why is an investor willing to pay more than the exercise value for the option?



c. If the price of the underlying stock changes to $33 per share, will the market value of the option increase,


decrease, or remain the same? Why



d. If Orne Corporation had issued a put option (instead of the call), would its value increase, decrease, or


remain the same if the price of the underlying stock increased? Why?



Question 2. (15 points) Pierre Imports is evaluating the proposed acquisition of new equipment at a cost of $90,000. In addition the


equipment would require modifications at a cost of $10,000 plus shipping costs of $2,000. The equipment falls into the MACRS 3-year


class, and will be sold after 3 years for $35,000. The equipment would require increased inventory of 6,000. The equipment is expected to


save the company $35,000 per year in before-tax operating costs. The company\'s marginal tax rate is 30 percent and its cost of capital is 11




a. What is the cash outflow at Time 0?



Cost of milling machine


Modifications to machine


Shipping costs


MACRS 3 year class


Salvage after 3 years


Increased inventory


Savings per year


Tax rate





























b. Calculate the net operating cash flows in years 1, 2, and 3?



c. Calculate the non-operating terminal year cash flow.



d. Calculate net present value. Should the machine be purchased?



Question 3. (15 points) Andrews Corporation plans a $10 million expansion. The firm wants to maintain a 45 percent debt-to-total-assets ratio in its


capital structure. It also wants to maintain its past dividend policy of distributing 30 percent of last year\'s net income. Last year, net income was $4




a. Calculate the amount of external equity needed.



b. If the company changed to a residual dividend policy, how much external equity will it need?



c. Is the company likely to change to a residual policy? Why or why not?



Question 4. (15 points) A U.S. company orders merchandise from a Japanese company at a cost of 100 million


yen. The merchandise must be paid for in yen





30-day forward


90-day forward


180-day forward



Yen per $1 $ per 1 yen



















a. How many U.S. dollars must be raised if payment is due today?



b. Is the dollar appreciating or depreciating against the yen? Explain.



c. How many U.S. dollars must be raised if payment is due in 90 days?



d. Who bears exchange rate risk, the U.S. company or the Japanese company or both? Explain.



e. Describe 3 ways in which the company can reduce exchange rate risk.



Question 5. (15 points) Kern Corporation entered into an agreement with its investment banker to sell 10 million shares of the


company\'s stock with Kern netting $225 million from the offering. The expected price to the public was $25 per share.


The out-of-pocket expenses incurred by the investment banker were $5 million.


a. What profit or loss would the investment banker incur if the issue were sold to the public at an average price of $25 per share?



b. What profit or loss would the investment banker realize if the issue were sold to the public at an average


price of $20 per share?



c. Is the agreement between the company and its investment banker an example of a negotiated or a bestefforts deal? Why? Which is riskier to the company? Why?



Question 6. (15 points) Reynolds Corporation plans to purchase equipment at a cost of $3 million. The company\'s tax-rate is 30


percent and the equipment\'s depreciation would be $600,000 per year for 5 years. If the company leased the asset on a 5-year


lease, the payment would be $700,000 at the beginning of each year. If Reynolds borrowed and bought, the bank would charge


11 percent interest on the loan.


a. Calculate the cost of purchasing the equipment with debt.



Cost of equipment


Depreciation per year


5-year lease


Lease payment -BGN year




Tax rate


After-tax rate



Purchase Option



































Cost of equipment


Depreciation tax saving


Total cash flow




b. Calculate the cost of leasing the equipment.



Lease Option




Lease Payments


Tax saving


After-tax payments



c. Calculate NAL? Should the company buy or lease the equipment? Why?



Question 7. (15 points) Marcal Corporation is considering foreign direct investment in Asia. The company estimates that the project would require an initial investment of $18 million. and generate positive cash flows of $3 million a year at the end of each of the next 20 years. The project\'s cost of capital is 13%.


a. Calculate the project\'s NPV.



b. The company thinks there is a 50-50 chance that the Asian country will impose restrictions on the company in one year.


If the restrictions are imposed, cash flows will be $2,000,000 per year for 20 years. If restrictions are not imposed, cash flows will be $4,000,000 per year for 20 years. Cost of capital remains the same. In either case, the cost will remain at $18,000,000 and cost of capital at 13%. Calculate the value of the real option by waiting one year to decide.



c. Apart from real options, discuss 3 qualitative factors that the company should consider when making its decision on accepting the new project.


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